Great Crash Of 1929 Fuels Lessons On Investor Psychology

Magnus Grimond, The Times (London), 23 Oct. 2004

Seventy-five years after the great Wall Street crash, scientists and fund managers increasingly believe that they can profit from the psychology that prompted investors to run for the exits during that fateful October of 1929.

That, and subsequent slumps, notably the dramatic events of October 1987, have prompted many official and academic studies into the causes. But most people end up explaining these cataclysms on the strange herd mentality that occasionally overtakes human beings.

However, what was once written off as irrational exuberance is now being turned to investors' advantage by both academics and moneymen alike. One City investment firm is using the prejudices of analysts and fund managers to pick winning stocks.

And in America's earthquake state, a professor at the University of California, Los Angeles (UCLA), thinks his expertise in predicting earth tremors can forecast when volcanic human emotions will erupt into market fissures.

The importance of our herd mentality in such events was recognised long ago. The title of Charles Mackay's 1841 book Memoirs of Extraordinary Popular Delusions and the Madness of Crowds showed exactly where he was coming from.

Whether it was the extraordinary"tulipmania" which overtook the Netherlands in the 17th century, or John Law's Mississippi Scheme and the South Sea Bubble in the next century, a series of financial manias were blamed by Mr Mackay on collective human lunacy.

However, Didier Sornette, of UCLA, says that this power of imitation is important in setting humans apart from other animals."Very few animals are able to imitate.

It is the attribute of very intelligent people. Right through life, it is the way we learn."

It can be a rational short-cut to gaining new skills. This might be simply copying someone else at school, or following other investors in a market, he says."It is a very important organising principle for people and investors."

Yet in its more negative form, before a crash, it leads to a"ripening", he says.

A bubble of what become unsustainable prices is inflated by self-feeding"positive feedbacks", of which imitation is one.

Professor Sornette cites four or five stages in this process. Initially investors react to good news. As prices rise, there is an increasing incentive for companies to invest and investors to borrow to buy their shares. He cites Japan in 1989 as a good example of this. Banks were prepared to lend more than 100 per cent of the value of a property because they assumed that rapidly rising prices would quickly more than cover the loan capital.

The positive mood becomes so extensive it is self-fulfilling."Everyone profits from the price rises, everyone feels richer and it boosts the economy," Professor Sornette says.

It is at this stage that the market becomes disconnected from the"fundamentals" - rational measures such as profits and dividends -and people start to talk of"the new economy". This occurred in 1929, 1962 and, notoriously, in the 1990s, when there was talk of a new economic"paradigm" brought on by technology.

Professor Sornette says:"This ripening can take several years -when fundamentals are so far removed from prices, the market has reached a degree of instability.

Then we think we can provide a degree of prediction of that instability."